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Reapproaching the Fiscal Cliff

In the wake of the election, Washington seems likely to steer clear of the worst of the spending cuts and tax hikes.

Now that the political lines for the next couple of years are clear, the so-called fiscal cliff stands first on the agenda for President Obama and the existing Congress. The matter is urgent. Unless something is done between now and year-end, some $660 billion in automatic spending cuts and tax hikes will almost certainly toss the economy into recession.

Avoiding it probably would have been easier with a Romney victory. By giving Congress an excuse to wait for the new administration to work out its budget, Romney would have offered both sides of the aisle a way to sidestep this difficult issue. But with Obama’s reelection, the effort to avoid the cliff now requires hard negotiations. The next few weeks doubtless will see a lot of give-and-take and even with the initial spirit of compromise, recriminations, too. Because neither side can concede until the last minute, it’s likely that little will become clear until late December. But it’s nonetheless likely that in the end, Washington will steer clear of the cliff, or most of it, offering a kind of last-minute holiday gift to the economy and markets.

During the coming period of negotiation and uncertainty, investors and business people need to keep in mind that no one in Washington wants to go off this cliff. Even before the election, Congress had voted to fund the government through March, indicating a clear willingness to at least kick the can down the road. What is more, a bipartisan group of eight senators, calling itself the “Gang of Eight,” was formed well before the election to devise at least a minimum down payment on the deficit that would forestall all the sequestration of discretionary spending, mostly on defense, something on which the 2011 debt ceiling compromise otherwise would have insisted. House Speaker John Boehner had already outlined the basis of a compromise on the Bush tax cuts. So this process began weeks ago. Still, some pieces of the cliff will be easier to level than others.

The easiest aspects to fix are the scheduled imposition of a broader-based alternative minimum tax (AMT) and the scheduled cutbacks in fees paid to doctors under Medicare and Medicaid. These issues amount to some $90 billion or about 14% of the cliff. Congress already has the legislation in place to avoid both. For several years now, it has passed special legislation to stop each from imposing fiscal restraint. The “ATM patch,” as it is called, regularly blocks this tax burden from spreading beyond the four million taxpayers who now suffer under it, to 32 million more. Its passage has become an annual event and a repeat should be easy to pass quickly in the closing weeks of the year. Similarly, Congress has so frequently sidestepped the mandated cut in doctors’ fees that the legislation is known as the “doc fix.” Another round on this front should impose little problem.

The tax increases implicit in the Affordable Care Act stand at the other end of the difficulty scale and may be almost impossible to avoid. After all, such an effort could involve unwrapping that huge piece of complex legislation. These taxes include special Medicare levies on wealthier taxpayers and extending Medicare taxes to investment income. While those burdens may irritate investors, they amount to only $25 billion, less than 4% of the fiscal cliff.

Two other aspects of the cliff—the end of extended unemployment benefits and the end of the partial payroll-tax holiday—will see some tough negotiations. Should Congress fail, these would amount to $162 billion in fiscal restraint. To be sure, the sides today seem far apart. Democrats want to continue both, in line with their earlier statements. Republicans want to end them. Much of the handicapping in Washington now suggests that Democrats will prevail, which would relieve this aspect of the cliff entirely. A compromise, already raised from both sides of the aisle, might allow for a gradual adjustment back to the original law. If that occurs over a year, the economy will avoid half this fiscal restraint in 2013 and if the adjustment is set to take longer, the economy will avoid still more next year. On this basis, a conservative calculation would indicate relief of at least another $81 billion or a reduction of 12.3%, and possibly more, in the cliff’s size.

If the Gang of Eight prevails, the economy will avoid all the spending cuts involved in sequestration. That would amount to about $90 billion, mostly in defense, or 13.6% of the cliff. But even if this particular approach fails, Congress still has other ways to relieve much of the strain. After all, the sequestration does not change the budgeted amount but only blocks the spending of what has already been appropriated. Given the precarious state of the economy and the clear desire in Washington to steer away from the cliff, it seems likely that even without Gang of Eight action on the deficit, lawmakers will find a way to spare the economy this restraint or delay it to later quarters or perhaps even to 2014.

The expiring Bush tax cuts are the most complex matter. If they lapse entirely, they will amount to fully one-third of the fiscal cliff. The parties’ positions on the tax cuts are long standing: Republicans want to continue them for all and Democrats want to continue them for individuals making less than $200,000 a year and couples with joint incomes of less than $250,000 a year. Two years ago, when the current rates were set to expire, the Republicans prevailed and Congress extended the cuts until the end of this year. It is not likely to repeat that pattern.

Two lines of compromise are open. One follows proposals from 2010 to raise the annual income limit for a hike in taxes, including taxes on capital gains and dividends, possibly to $1 million. In that case, the economic effect would be slight indeed. An alternative offered by Boehner would avoid these hard negotiating positions by pursuing more fundamental tax reform. Proposals to reduce statutory tax rates and limit deductions have gained favor with legislators from both parties and the White House. These reforms could remain revenue neutral or, as indicated recently, raise revenues. Regardless of how the disputants eventually work this out, it does seem likely that the economy will avoid all or most of this aspect of the cliff as well.

The exact nature of this debate and the ultimate compromises remain obscure. But the probabilities still suggest that the United States will avoid the bulk of the cliff. At most, it looks as though the economy will have to bear $150 billion to $200 billion of fiscal restraint in 2013. That is a significant number, but it equals barely more than 1% of gross domestic product. It is not enough to create the severe recession of which the Congressional Budget Office warned when assessing the entire cliff. It is likely not even enough to drive this slow-growing economy into a mild recession. It will, however, help ensure that growth remains sluggish at best.

About the Author

Milton Ezrati

Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. His latest book, Thirty Tomorrows, linking aging demographics and globalization, will appear next summer from Thomas Dunne Books of St. Martin’s Press. See more of his articles about the economy here.

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